Japanese investors are moving money overseas, and that means more liquidity for some emerging markets and pain for others.

As the U.S. Federal Reserve ends its asset purchases, the Bank of Japan’s aggressive easing — Abenomics — means a weaker yen and negative real yields. In the global search for yield, total annual financial outflows from Japan rose by $137 billion in the year to September and are close to the post-global financial crisis high. Portfolio outflows were the key driver … rising by $254 billion, led by investments in long-term debt, followed by equities.

“Worryingly however for EMs, the more stable source of funding – direct investment – contracted,” notes Shweta Singh at Lombard Street Research in a recent report.

The benefit for emerging may be short-lived, but Singh says that “there are increasing signs that the BOJ may be forced down the path of permanent QE, implying more yen depreciation and negative real yields. Perma-QE or not, Japan will see more outflows.” So who benefits? Again, Singh:

“The main beneficiaries of BOJ outflows are likely to be those economies that have a greater capacity to increase debt, a better starting point on the competitiveness front and an export basket that is differentiated from Japan’s. India, Mexico and emerging ASEAN may see some benefits, particularly if outflows from Japan are in the form of relatively stable direct investment, something which is currently missing … The bad side of the coin is the competitiveness pressure on emerging markets. EMs that are more reliant on external demand will continue to bear the brunt of Japan’s policy of exporting deflation against the backdrop of sub-par global growth. This is especially the case for those economies whose export structures are similar to Japan’s – South Korea being an obvious example.”

Japan allocations have been skewed to the U.S., which accounts for 52% of portfolio outflows, and 80% of that is treasuries. But, Japan’s Government Pension Investment Fund has raised its allocation targets for foreign debt and equities. Singh writes:

“Japanese flows to the U.S. will also lead to more dollar strength, intensifying the squeeze on EMs holding U.S.-dollar-dominated debt. EMs cumulatively received only 10% of the increased Japanese flows and, unlike in the case of developed markets, there was a preference for equities. The flows to EMs were concentrated in Asia, with China/HK making up the bulk, followed by the ASEAN region (Malaysia in particular), Korea, Taiwan and India, in that order. Outside of Asia, Brazil, Mexico and South Africa are some of the larger recipients of Japanese flows.”

With oil prices in free fall in recent weeks, the risk of upside is good for short-term traders.

So say Morgan Stanley analysts Adam Longson and Elizabeth Volynsky in a note today. Oil prices have fallen more than 1% on Monday; the U.S. benchmark was recently trading near $84.81 per barrel. Morgan Stanley’s analysts write:

“We are becoming constructive on oil through year-end. Calling a bottom is tough and macro concerns could continue to weigh on prices, but the recent sell off has created an attractive risk-reward. While fundamentals have been poor through much of the summer and fall, much of the last leg of downside has simply been a result of financial flows, sentiment and macro fears. Physical markets are strengthening, with more improvement ahead, which historically has transmitted into prices on a delayed basis.”

Morgan Stanley analysts think markets are too focused on demand for refined product, such as gasoline and distillates, at the expense of the greater oil demand picture, long term. Japan is shifting toward coal and LNG from oil for power. But most countries are reporting healthy demand growth, especially for gasoline, and there is no sign ahead of a “sharp decline” in product demand outside of Europe, Japan and Mexico, they write. (See table below.) ”The U.S., China and even Europe are growing faster than year-to-date trends in the latest months, and product cracks [profits] are also healthy.”

“From a crude standpoint, OPEC is right to expect a material improvement in demand. As a result, we would not be surprised if the cartel waits to see how markets evolve this winter before making any hasty decisions. That said, Venezuela has openly asked for an emergency meeting to halt the slide in crude prices.”

Total year-over-year change in oil-product demand has fallen the most in Mexico and Japan, but is up in Brazil. Source: Morgan Stanley

Renowned international value investor David Herro has a youthful grin, but he’s been around the block (and the world) a few times. One lesson he’s learned is to avoid the quick momentum trades.

He finds himself these days in a volatile trader’s market with a selloff seemingly taking root globally. But Herro is standing firm, scouring the globe for ideas, and then evaluating a company’s cash flow, valuation and management before investing. Indeed selloffs are good news for Herro, who built a position in Japanese stocks in 2012 that paid off smartly.

Herro is chief investment officer of international equity at Chicago-based Harris Associates, where he co-manages The Oakmark International Fund (OAKIX), which is closed to new investors, The Oakmark International Small Cap Fund (OAKEX), and The Oakmark Global Select Fund (OAKWX). Each has beaten its benchmark since the market bottomed in 2009. In 2010, Herro was named one of Morningstar’s managers of the decade.

Herro told Barron’s earlier this year that he thought emerging market stocks were too expensive and, despite a selloff in September, he still feels that way. But he’s capitalizing on the developing market growth nonetheless; read on to find out how.

Barrons.com: How are you positioned in emerging markets?

Herro: We are underweight emerging markets. There was a time when we were more than 20% emerging markets. Just on valuation, I am somewhat bearish until stock prices come down. I am a long-term bull on emerging market economies, but at this stage, I am not a bull on emerging market stocks. Investors should be cautious about emerging market stocks until prices in emerging markets fall off, and it is safe to look at them again.

Q: But what about the power of the emerging market consumer, and all that future growth?

A: You can buy companies in developed markets selling at much better values, with exposure to structural growth in emerging markets like Kering (PPRUY and KER.France), the owner of Balenciaga and other luxury brands; Diageo (DEO), the global drinks company; Daimler (DDAIF and DAI.Germany) and Bayerische Motoren Werke (BMW. Germany), the luxury auto producer. Compagnie Financiere Richemont (CFRUY and CFR.Switzerland) – its big brand is Cartier. Prada (PRDSY and 1913.HongKong) at this price is also attractive. In our core international fund, our only directly-domiciled emerging market stock is Samsung Electronics(005930.Korea), which is 2.6% of the fund. On revenues, we are probably in the low to mid 20% emerging markets exposure in that fund.

Q: Why luxury goods producers?

A: They benefit from the move in emerging markets as people shift up from the lower and middle classes into upper classes.

Q: What is the advantage of getting emerging market exposure indirectly?

A: You get lower-priced stocks, stronger corporate governance, and while emerging markets pick up, these companies are doing well in Europe and the United States. The trend in emerging markets is for the consumer to get stronger and stronger over time, so the best way to take advantage of this is to buy low-priced stocks based in the West with a lot of exposure to … (please continue to the next page …)

But Citi Research says that while Modi implored Japanese businesses to “Make in India,” there is apprehension about India’s fundamental competitiveness. Some investors in Japan are interested in India bonds, but buying is limited.

Citi’s Rohini Malkani and Anurag Jha met with investors in Japan, a week after Modi’s visit, and coal was among the points of concern for Japanese investors. India recently voided years of coal mining licenses. Investors said uninterrupted power supply was an essential prerequisite in light of the coal “imbroglio.” They write:

“Interestingly, our equity analyst notes that ‘India’s thermal power plants are operating at 15-year lows in terms of utilization levels and could generate 20% more power, if provided sufficient coal and gas.’”

India’s coal import demand could benefit companies like Singapore’s Noble Group (NOBGF) and even U.S. producer Peabody Energy (BTU), which has production in Australia. Credit Suisse recently suggested energy investors look instead to Reliance industries but was neutral on Coal India. (see “India: Stock Picks As States Reform.”)

The latest friendly meetings between Indian Prime Minister Narendra Modi and Japanese Prime Minister Shinzo Abe were driven by shared fear of China’s might, but the result exposes the difficulties in cross-border investing.

“India hopes to profit from growing unease among Japanese companies about the risks of operating in China … the Japanese government and businesses increasingly view India as an important location for investment, but for now more as a hedge against, [rather] than as a replacement for, China,” write Aditi Phadnis and Tobias Harris at Teneo Intelligence.

Modi’s five-day trip to Japan didn’t result in new initiatives in the existing bilateral security relationship, though the two governments may collaborate on military equipment development “over the medium term,” they write. Japan is reluctant to allow India the right to reprocess spent fuel generated from Japanese equipment and wants inspections that go beyond India agreement with the International Atomic Energy Agency.

In 2012-2013, trade between India and Japan was $18.5 billion, nearly triple the level of 2005-2006, but still small relative to potential growth in trade. Phadnis and Harris write that the Modi government must introduce several reforms to enhance India’s attractiveness as a destination for Japanese foreign direct investment:

“India requires $1 trillion in foreign investment in the infrastructure sector alone. A large chunk of this investment needs to come from the private sector. Japan has begun to contribute to this need and has already invested Yen 450 billion ($4.5 billion) in the Delhi Mumbai Industrial Corridor project. Indian infrastructure has also benefited from an additional Yen 232 billion ($ 2.32 billion) in aid extended by Japan in 2013. Moreover, Japanese companies such as Mitsubishi (MSBHY), Suzuki Motors and Toshiba (TOSYY) have increased their investments in the Indian market. On the flip side, few Indian companies operate in Japan. … At [this weeks meetings], Modi announced the extraordinary step of creating a unit in the prime minister’s office that would focus solely on the needs of Japanese businesses.”

The iShares MSCI India ETF (INDA) is up nearly a point today. The iShares Core MSCI Emerging Markets ETF (IEMG) is up 1.24%.

The biggest losers have been Taiwan, Korea and China, Societe Generale says. The iShares MSCI China ETF (FXI) has dropped 13.7% during the past three months, the iShares MSCI South Korea ETF (EWY) has fallen 9% and the iShares MSCI Taiwan (EWT) has dropped 3.1%. The iShares MSCI Japan Index ETF (EWJ), meanwhile, has gained 16.7%.

In a separate report, Societe Generale’s Albert Edwards fretted that the plunging yen could lead to a replay of the 1997 Asian currency crisis. He writes:

It seems investors may have forgotten that yen weakness was one of the immediate causes of the 1997 Asian currency crisis and Asia’s subsequent economic collapse…

A weak yen comes at a time when the Chinese and other major EM countries are seeing a deteriorating BoP situation  similar to what we witnessed in the mid 1990s. I studied Asian economies very closely at that time as the average UK pension funds had almost 10% of their assets parked in Asia ex Japan! Hence when I see a sharp rise in Chinas real exchange rate and deteriorating [balance of payments], it rings alarm bells. China is not the most vulnerable of the EM currencies to a weak yen, but this conjunction could easily trigger a currency crisis as growth is crushed. High levels of FX reserves are no protection  if they are sold to prop up Asian currencies this will only impart a further deflationary monetary squeeze. Boom will turn to bust.

Edwards has been a bear for quite a while (though not permanently, as his reputation suggests) so feel to disregard what he says. Emerging market bulls do so at their own risk.

Add the Bank of Japan’s steps to weaken the yen to the problems facing China. Here’sMarketfield’s Michael Shaoul on the subject:

Agence France-Presse/Getty Images

The dramatic change in the BoJ’s monetary stance has led to a sharp devaluation of the JPY against other currencies but given the prolonged period of appreciation experienced against major currencies such as the USD and EUR the JPY is still on the expensive side of its historical range….

The same is not true with regards to China. Since 1999 the CNY/JPY exchange rate has had a well defined range between roughly 12 and 16.5. At the lower band Chinese exports are very competitive with Japanese exports and at the higher band the opposite is true. As recently as last September the CNY/JPY was at 12.4, but the last 6 months have seen a dramatic move in the rate up to 15.5, meaning that Japanese exports are starting to become very competitive with Chinese.

For Shaoul, the Yuan/Yen trade is the key currency pair to watch–and may be even more important than the euro/dollar. He writes:

This strikes us as a key battle within currency markets, perhaps even more important for actual economic activity than the much more widely watched USD and EUR crosses (although the latter is still a very important indicator of risk appetite). China appears to be the big loser in Japan’s sudden change of monetary tack. With political tensions already running high between these two nations we would expect the exchange rate to become a matter of considerable tension in the months ahead.

As beyondbrics pointed out, China’s stock market has been getting hammered this year, even as Japan’s rises. The iShares FTSE China 25 Index (FXI) has dropped 13.6% during the past three months, while the WisdomTree Japan Hedged Equity ETF (DXJ) has gained 15.5%.

This weekend’s G20meeting was supposed to shed light on the state of the so-called currency war–but instead its members acted as though one didn’t exist. Real or imagined, however, emerging-market investors ignore FX at their own risks.

Bloomberg

Talk of currency wars have been heating up since Shinzo Abe became Japan’s prime minister, after running a campaign predicated on bringing rising prices to a nation that has suffered from near-non-stop deflation during the past 20 years. His election caused the yen to drop 20% versus the dollar–and weaken against Asian currencies like the Korean won, on the hope that Japan would follow in the footsteps of the U.S., England and Europe, by using unconventional measures to try to stimulate the economy and boost inflation.

Some argue that these measures are legitimate attempts to boost economies that have yet to fully recover from the Great Recession–and I’m sympathetic with this camp. No one wants a repeat of 1937, when the U.S. hike interest rates too soon and cause the economy to crumble. It didn’t fully recovered until World War II. Keeping interest low–and taking unconventional steps to when rates can’t go any lower–is a justified response to a crisis unlike most of us have ever seen.

But even if the low-rate policies are justified, they still have consequences for emerging-market nations. That’s because interest rates are one of the main movers of currencies, and when one country has ultra-low rates, investors will look to higher-yielding ones to meet their income need–known as a carry trade. As a result, the currencies of low-yield countries will fall, as investors sell it in favor of high-yielding currencies.

And for some emerging markets, that creates major problems. Take Chile. Its central bank kept its interest rates unchanged at its Feb. 15 meeting, despite being caught between strong consumer demand–which would call for rate hikes–and lackluster exports–which would typically require lower interest rates to rectify. The Financial Times took a look at Chile’s tough spot here.

Chile can’t hike rates, however, because that would cause its peso to go up and ding external demand for its goods, even if that would cool the local economy. And it can’t raise them because that would cause the local economy to heat up even more, even if it solved the export problem. That leaves its central bank with one option: Currency intervention.

Of course, none of this new. Countries have always done what they thought best for their own economies–including keeping their currencies weaker than they should have been to make themselves more competitive and build up large currency reserves.

It just didn’t feel like a war when the global economy was booming, notes HSBC currency strategist David Bloom. Now emerging market investors will have to try to differentiate between those countries that will tolerate a rising currency and those that won’t he said in a note on Feb. 14.

Mexico, South Africa, India and Indonesia are among the countries more likely to allow appreciation of the their currencies, while Colombia, Turkey and South Korea are among those that are most likely to take steps to weaken them, HSBC says.

Just as important as the individual countries, however, is the impact on other asset classes. For instance, investors have been moving into local-currency emerging market bonds–such as those found in the Market Vectors Emerging Market Local Currency Bond (EMLC) exchange traded fund–but these bonds will be be more volatile because they rise and fall as the dollar weakens or strengthens against those currencies. Likewise, some stock markets that look primed to move higher might fall because of currency fears. For instance, the iShares MSCI South Korea Capped ETF (EWY)

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. Barrons.com’s Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools. She studies multiple languages and photography.